Firm, Theory of the

Firm, Theory of the, study of the way businesses behave with respect to the purchase of inputs, production techniques, output quantities, and pricing. The traditional theory assumes that firms aim to maximize profits. Newer theories attempt to take into account the complex character of many businesses today, where it is common for a firm to consist of many sub-groups to which decision-making is decentralized to a greater or lesser degree, depending on the firm. Thus, it is argued according to the satisficing theory of the firm, firms subjugate the aim of maximizing profits to one of achieving “satisfactory” profits, as they pursue with equal or greater attention such other aims as maximizing sales or growth.

The behavioural theory of the firm recognizes that within large complex businesses there is inevitable conflict between the individuals and sub-groups that make up the whole and that therefore it is from the interaction among the firm's various people and parts that organizational objectives evolve. The developers of the theory suggested that firms should set various goals (such as production, market share, stock, sales, and profit), each of which are the prime responsibility of specific managers. These managers will then pursue a course of action that will most help achieve their specific goal but they will also at times need to make compromises when dealing with other managers who are pursuing different goals. Out of this bargaining process will come overall goals, which are felt to be satisfactory. Supporters of the behavioural theory also argue that, contrary to the traditional theory which assumes that decisions are made rationally, in practice goals are imperfectly rationalized and therefore may be inconsistent with existing policies. Additional points they make are that objectives change over time as a result of experience, and that poor communication between senior management and their juniors (to whom often considerable decision-making powers are devolved) often make it difficult for objectives to be imposed from above.

Underlying the behavioural theory of the firm are two main assumptions. One is that in large businesses ownership is separate from control; in other words, it is the managers rather than the shareholders who set the objectives of the firm. The other is that managers are more interested in, say, output or sales, than they are with profit because it is these things that determine their “managerial utility” and therefore their value to the firm.

The theory has helped provide insights into the way that large firms operate, but there are many who argue that a single goal of profit maximization is likely to approximate more closely to what other firms do than other objectives. The theory of the firm bears some relation to organization theory.